Oil prices are falling again

AS I WRITE this column, oil futures are
hovering at about $41.86/bbl (W TI). Brent
crude is nearly $3 higher at $44.61. This is
not the direction the industry wants commodity prices to go. More importantly, it
is not the direction the industry expected
it to go – not now, in late July, during the
peak summer driving season in the US
when fuel consumption is supposed to increase and retail prices rise accordingly.

A month ago, crude futures were flirting with the $50 mark.
Oil and gas companies were making plans to ramp up again.
Industry executives were preparing for a recovery. From all
appearances, it seems that recovery may be delayed.

So, what now? We have moved into the third quarter of a
new year, and companies are starting to report second-quarter
earnings. It still looks pretty dismal. Even energy giants like
ExxonMobil are concentrating on reducing costs rather than
expansion. Exxon, which purchased shale producer XTO
Energy in 2009 for $41 billion, a deal that
drove the oil major’s net debt to $35 billion
from a previous cash surplus. Faced with
declining revenues and net income, in
April of this year the Irving, Texas company lost its coveted AAA credit rating.

With low fuel prices at the pump, even
the refinery sector is suffering. Margins have fallen due to
excess inventory and reduced driver demand. So the refining
business hasn’t bailed out the integrated majors this year as
it has in the past.

If prices collapse again while hedge funds and short-sellers
take their profits, energy companies will be in worse trouble
than ever. Although they have taken an axe to spending and
laid off tens of thousands of employees, many of them are in
no position to survive another wave of low prices. They are
still leveraged to the hilt financially and desperately need
cash flow to meet their obligations. However, many E&P
companies are using revenues to finance drilling operations
rather than pay down debt. Their hope is they can do both,
but low prices often mean uneconomic wells and insufficient
cash flow. A well that might be marginally economic with
$50 oil doesn’t perform as well at $40, and is a disaster at $30.

At the risk of stating the obvious, we have a supply-and-demand problem. US oil and product inventories have hit anall-time high of approximately 1. 4 billion barrels. This is fargreater than would be expected during the summer whenpeople are driving more and taking vacations. Blame thePermian Basin producers if you like. Unlike the other majorUS shale basins (Bakken, Eagle Ford, etc.), where we haveseen production declines, operators in the Permian believethey can still drill profitable wells. Maybe they can with $50oil, but how about $40? How about $30? And how much doesthat production help to keep US inventories high and priceslow?The Saudis are the obvious villains in the eyes of many USproducers. They have refused to cut production to make aplace in the market for the roughly 50% increase in NorthAmerican oil since 2009. Imagine that! Why wouldn’t theygladly hand over market share to the Americans? We’d do thesame for them, right?But not only have the Saudis not cut production, they haveincreased it. The Saudis seem convinced that the fossil fuelindustry is dying, and they have ramped up production tosell their crude while they believe there is still a market forit. Saudi Arabia’s 20-year strategy is based on the assumptionthat renewable energy is the wave of the future. They don’tsee any point in conserving what there may not be a marketfor in the years to come.It doesn’t matter if we disagree withthat point of view; it is clear that is theSaudi strategy. And Russia seems to beoperating on the same premise. Don’t ex-pect either nation to cut or freeze produc-tion levels despite occasional rumors theywill do so. More than likely, the rumorsare a marketing ploy.In short, with this significant imbalance between supplyand consumer demand, it is reasonable to expect prices toremain low until the situation changes.Rusty Braziel, president and principal consultant for RBNEnergy in Houston, addressed this issue in an interview inthe June issue of OGFJ. “We are witnessing the impact ofcreative destruction,” said Braziel. “The survivors will be thosecompanies that learn how to adapt to today’s marketrealities.”Boom and bust cycles will continue to come and go, saidBraziel. “The obvious lesson is that nothing lasts forever. This[downturn], too, will pass. But the more important lesson isthat the winners are those that position themselves in thebust cycle to ride the next boom up. The natural tendencyin a busy cycle is to hunker down, and to some extent, allmust do that. But if a company can align its opportunitieswith what the next market is likely to bring, it can be hugelysuccessful, regardless of when the next cycle happens.”I would add to that – get your finances in order. A heavydebt load among US oil companies has ballooned seven-foldin a decade, according to a Houston Chronicle analysis. Thatdebt is far too high and will delay the eventual recovery.“With the significant imbalancebetween oil supply and consumerdemand, it is reasonable toexpect prices to remain low untilthe situation changes.”